The relation between exchange rate and fundamentals: A study on Turkey

After the collapse of the Bretton Woods system, flexible exchange regime was used widely and it caused fluctuates on exchange rates and so new models were developed to describe the volatility on the exchange rates. In the structural macro based models that are used for describing exchange rate behaviour, it is accepted that exchange models are determined by fundamentals such as money supplies, inflation and interest rates. But the macro based models that are used for describing the exchange rate behaviours substantially failed in a short span of time. Empirical failure of macroeconomic models to explain short-term exchange rate movements encouraged the economists to investigate the causes of this exchange rate disconnect puzzle and to look for the new models to determine the exchange rates. What is meant by deviation of the exchange rate is not the state in which real effective exchange rate deviates from long-term real exchange rate; it is the state in which there is a weak correlation between key macro economic variables and mid and short-term exchange rates. When we examine the factors causing deviations in exchange rate, we find ourselves face to face with the general characteristics of the market(order flow, transaction costs), the differences in the behaviours of the market participants (chartist and fundamentalists, noise traders) and the differences in the appraisal attitudes of the companies(consumer currency pricing, produces currency pricing). In this study, the relation exchange rate and fundamentals was tested by using unit root and VAR( (Vector Autoregressive) methods with the help of the the monthly data gathered between 2003:Q5-2012:Q5 which belongs to the Turkey's economy. The results show that, there is a weak mid and short-term correlation between exchange rate and fundamentals and that are interpreted as exchange rates disconnect from fundamentals. Keywords: Exchange Rate Disconnect, Purchasing Power Parity, VAR Model, Noise Traders, Order Flow.